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Someone with a background in economics, business, philosophy, and watching the world. I want it to be less Krazy!
My view point is reality, not the make believe world of made up money and the use of force against the innocent. I argue from the economic view point of Austrian economics and the position of individual rights, freedom, reason, and rational self-interest as defined by Ayn Rand.

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Sunday, August 14, 2011

Self-Fulfilling Fantasies: US Treasury Bonds

Number one on my list of fantasies is the US Treasury Bond. (Just for the record, in this context I mean nightmares. I do have good fantasies!) People feel US Treasury Bonds are safe. Are they?

The usual reason given for the safety of US Treasurys is that they are backed by the ability of the US government to dip into the pocket of the most-wealthy nation on earth to meet interest payments and redeem the bond upon maturity. Well, yes, that is true, still true. But that proposition does have limits, limits that have not been stated or acknowledged before, but need to be seriously considered, soon. (Notice that the wakeup call of the S&P downgrade of US Treasury Bonds has not resulted in honest reconsideration of the path of the Obama administration, but has caused several loud calls for destroying the remaining limited independence of the credit rating companies.)

There is also another issue that isn’t addressed in the basic reasons for the safety of the US Treasury Bond, prices. You see (and I am sure that many of you do see) the price of the bond is related to the interest rate that it pays, which in turn is related to the interest rates paid on other bonds around the world. If interest rates begin to climb, and the secondary market for Treasury Bonds (where bonds purchased from the Treasury are resold), even the Treasury itself, need to compete for funds, the interest rates for the bonds will climb. The consequence will be that the price of the bonds will fall. So Treasury Bond prices do change. If interest rates move, say, a whole percentage point upward what happens to the price? The current benchmark 10 year Treasury Bond has a yield (interest rate) of about 2.4% (the date of my first draft being somewhat different from my publishing date). So I am suggesting that it went from 2.4% over time, however long you want, to 3.4%. The latter interest rate is still very low. Historically, this bond has been much closer to 5%. Even at 3.4%, with taxes at roughly 25% and inflation around 2%, the bond isn’t making you any money (at 2.4% you are taking a loss). (Of course, foreign governments aren’t paying taxes!) But, a bond purchased originally at 2.4% will not yield the new market rate and can’t be sold for the original purchase price (nominally $10,000). Instead it must be sold for the amount that will bring the current market rate of 3.4%. (or $240 – the actual dollars paid in interest – divided by the new interest rate) which is close to $7058 ( there are issues of time to maturity, when you receive back your $10,000 that will adjust the actual sell price). You have lost roughly 29% of your principal. You see, relatively small moves in interest rates will have significant effects on the market value of your bond.

This example demonstrates that bonds are no safer in terms of maintaining your principal than any other asset, unless you hold to maturity. How safe is that? Depends upon the inflation rate doesn’t it. When thinking of long-term monetary values, don’t think in terms of currency, that is, fiat currency. Think in terms of some real, basic thing that you use in daily life, like a loaf of bread, or a pound of ground beef, or a latte in Paris, whatever. You will connect the rate of inflation to your currency denominated assets and be able to better realize what is happening to your capital. The bottom line is that US Treasury Bonds are very risky. (I won’t even go into the fact that you have put your savings into the hands of people like Obama, Bernanke, and Geithner.)

Many, if not most investors know these facts, so why are they still running to US Treasuries? Context. Or, a perhaps better way of putting it, where else are they going to put their money? There are a couple currencies that are considered strong, i.e., the Yen and the Swiss Franc. Both of these have been bid up sky high (much to the dismay and panic of the authorities and business people in those countries). There isn’t any real room there for more money. Other currencies are not considered safe by the populations of those countries. The best current example of that is the eurozone. This group of “developed countries” have people making decisions who are more concerned about voters than solvency. People who wish to protect the value of their liquid assets are scared of what these politicians will do (not to mention the so-called economists who do not think stability or production as important to economic health). The person holding liquid assets wants to put his property somewhere that the whims of the politicians can’t destroy it.

The bond markets for stronger countries, such as German and Austrailia, are small, very small in comparison to that of the US, and can realistically take only a small portion of the available funds. So for anyone wanting to get out of their home market, out of their currency, out away from their authorities, the US is still a better place. It just gives you a good idea of how bad it is elsewhere that the US dollar and the US Treasury Bond are about as good as it gets.

The result is that Obama, Bernanke, and Geithner feel pretty strong and confident, in spite of the downgrade of US government bonds by S&P. Again, isn’t it amazing that the politicians in other countries scare their populations more than the US trio of idiots.

The above discussion also gives you some idea of what could be the future for the cost of gold in fiat currencies. The gold market is smaller than the market for the Yen or even the Swiss Franc.

At this point I should explain how the bid/asked market functions: it is the margin that moves a market, especially a auction market like stocks, bonds, currencies, commodities. It is not the total demand or ownership. It is the most recent orders, their size, their volume, and which side of the transaction they are on, buy or sell, that moves the market. The traders do what they can to meet the reqirements of the open orders, moving the price as required to elicit corresponding orders (a buy order to match the existing sell order) to clear the market. Higher volumes of demand for a item, like gold, will send the price up. The higher the volume, the faster and larger the price movement.

So if people really begin to consider gold as safe and a real alternative to fiat currencies, the current price will be considered very low. Any kind of movement into gold from these other markets will send the gold price to astounding heights and will really scare a lot of people.

What will be interesting to watch (but not to live through) will be the point at which people begin to doubt that US government assets are a good idea, including the dollar. We don’t even have to worry about China or Japan for things to get ugly. If just foreign banks, businesses, and individuals begin to sour on our debt, its yield will move strongly upward and its market price downward. The budget deal and all of the carefully crafted, make-believe scenarios will be revealed as so much fantasy. These scenarios (models) are also among my favorite nightmare fantasies.

2 comments:

How can you tell that the gold market is smaller than the Yen or Swiss Franc market. This is surprising to me, but I don't know exactly what this means. Is it the dollar amount traded on a daily basis?

Jack, thank you for your question. I take it in terms of volume and dollar amount, not the total owned. The Swiss economy in 2009 had imposts and exports of production goods totaling about $327B. Then there are services, investments, banking, and speculating activities which all require demand for Swiss Francs. If I use a conservative number of $400B for that year and divide by 250, roughly the number of business days in a year, we come up with a figure of $16B a day. For the gold market to average that volume, using a price of $1500, it would need over a million ounces a day, on average. Now, I am not including in what I am calling the gold market the gold that is used in jewelry or in production. I am talking solely about financial or currency use, i.e., those people who regard gold as a store of value or at least as a protection from government activity. Now if you look at the trading volume of the London bullion market, it would appear that these numbers are similar, the demand for the Swiss Franc and the demand for gold. But there is a difference. Much of the current activity in London is from traders who buy and sell, often several times a day. They are in fact trading the claim to the same bullion over and over again which is also true of at least some of the buyers and sellers of Swiss Francs. But still, the majority of buyers and sellers of Swiss Francs are people who are using the Francs in business. The equivalent in the gold market would be people who are purchasing gold to hold and not to speculate. That portion of the gold market is smaller, and smaller than the Swiss Franc market. If the volume of dollar demand for gold to hold took up a larger percentage of the London Bullion Exchange activity, the price would soar.